Cash Flow Statements Notes

  1. OBJECTIVE

 

The objective of IAS 7 is to require the provision of information about the historical changes in cash and cash equivalents of an entity by means of a cash flow statement, which classifies cash flow into:

  • Operating Activities
  • Investing Activities
  • Financing Activities

 

The standard requires the cash flow statement to be presented as an integral part of the financial statements.

 

All entities need cash to conduct their operations, discharge their obligations and provide returns to their investors.

 

The cash flow statement, taken together with the other financial statements, helps users to evaluate the position and performance of the entity.

 

Cash flow statements assist in assessing the ability of an entity to generate cash and cash equivalents.  Also, cash flows generated in the past are often used as an indicator of future cash flows.

 

DEFINITIONS

Cash comprises cash on hand and demand deposits.  Bank overdrafts, because they can be repayable on demand, are often included as a component of cash.

 

Cash equivalents are short term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.  They are held to meet short-term cash commitments rather than for investments and usually have a maturity of three months or less.

 

Cash flows do not include movements in cash and cash equivalents.  It is considered that such items are part of the cash management of an entity rather than part of its operating, investing and financing activities.

 

 

OPERATING ACTIVITIES

These are the main revenue producing activities of the entity.  The cash flow from operating activities is a key indicator of the extent to which the operations of the entity has generated cash to:

  • Repay loans
  • Maintain the operating capability
  • Pay dividends
  • Make new investments

Without using external sources of finance.

 

Examples of Cash Flows from Operating Activities

  • Cash receipts from sale of goods and the rendering of services
  • Cash payments to suppliers
  • Cash payments to employees
  • Cash payments/refunds of income tax
  • Cash receipts from royalties, fees, commissions and other revenue

 

INVESTING ACTIVITIES

These are the acquisition and disposals of long-term assets and other investments.  It is important to disclose the cash flows from investing activities separately because these represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.

 

Examples of Cash Flows from Investing Activities

  • Cash payments to acquire property, plant and equipment and intangibles
  • Cash receipts from sales of property, plant and equipment and intangibles
  • Cash payments to acquire an investment in shares or loans in other entities
  • Cash receipts from sale of investments
  • Cash advances and loans made to other parties (non-financial institutions)
  • Cash receipts from the repayment of advances and loans made to other parties (again non-financial institutions)

 

FINANCING ACTIVITIES

These are activities that result in changes in the size and composition of the contributed equity and borrowings of the entity.  The disclosure of cash flows arising from financing activities is useful in predicting claims on future cash flows by providers of capital.

 

Examples of Cash Flows from Financing Activities

  • Cash proceeds from issuing shares
  • Cash payments to owners to buy back shares
  • Cash proceeds from issuing debentures, loans, notes, bonds, mortgages, etc
  •  Cash repayments of amounts borrowed
  • Cash payment reducing the liability relating to a finance lease

 

REPORTING CASH FLOWS FROM OPERATING ACTIVITIES

The reporting of cash flows from operating activities can be either by:

  • The Direct Method, whereby major classes of gross cash receipts and gross cash payments and cash receipts from customers, and cash payments to suppliers are disclosed Or
  • The Indirect Method, whereby profit or loss is adjusted for the effects of transactions of a non-cash nature and the accrual or deferral of past or future operating cash receipts or payments e.g. profit adjusted for depreciation and any increase in trade payables and accruals.

 

The standard encourages the use of the direct method as it provides information which may be useful in estimating future cash flows.

 

Interest and Dividends

Cash flows from interest and dividends received and paid should each be disclosed separately.  IAS 7 does not specify the classification of these under either operating, investing or financing activities.  However, each should be classified in a consistent manner.

 

Taxes on Income

Cash flows from taxes on income should be separately disclosed and classified under operating activities unless they can be specifically identified with financing and investing activities.

 

DISPOSAL OF A TANGIBLE NON-CURRENT ASSET

The disposal of a tangible non-current asset has two implications for a cash flow statement:

  • Adjust the profit before taxation for any profit or loss on disposal, if a loss add to profit before taxation and if a profit deduct from profit before taxation And
  • The sale proceeds will be included under the heading “investing activities”.

 

CONSOLIDATED CASH FLOW STATEMENTS

In addition to the usual cash flow items indicated earlier, when the consolidated cash flow statement of a group of companies is being prepared, there are potentially three other entries required in the statement:

  • Dividends received from associate companies and/or joint ventures
  • Dividends paid to non-controlling interest
  • Purchase of subsidiary undertakings

 

  • Dividends Received from Associates or Joint Ventures

Such dividends, net of any tax on them if applicable, are included under the heading of “Net Cash Flows from Investing Activities”.

  • Purchase of Subsidiary Undertakings

Where a subsidiary is acquired during the period, the acquisition is recognised in the cash flow statement if there is a cash element of the purchase consideration.

 

Any non-cash element of the consideration, e.g. shares, loan stock, etc is excluded from the cash flow statement.

 

The cash consideration included will be:

Cash paid to acquire subsidiary

  • Cash holding of subsidiary at acquisition

(or + bank overdraft of subsidiary at acquisition)

 

The total net cash cost of acquiring the subsidiary is included in the heading “Cash Flows from Investing Activities”.

 

On disposal of a subsidiary the cash inflow will be:

Cash received on disposal

  • Cash holding of subsidiary on disposal

(or + bank overdraft of subsidiary at acquisition)

 

Again, only the cash element of any consideration received is included in the cash flow statement.

 

[Note, however that receivables, payables and inventories of the subsidiary that exist at the date of acquisition must be excluded when calculating the increase or decrease of receivables, payables and inventories in the cash flow statement.  Furthermore, other relevant balances at acquisition must be taken into account in preparing the cash flow statement for the year of acquisition]

 

Consider the following comprehensive example of a consolidated cash flow statement.

 

SHVN Limited is a long established company operating in the hotel and leisure industry.  In recent years, it has diversified into other areas, achieving its corporate expansion by the acquisition of other companies.

 

LIMITATIONS OF THE CASH FLOW STATEMENT

When users of the financial statements are assessing the extent of future cash flows, then cash flow statements, though useful, should not be considered in isolation.  Information from income statements and balance sheets, together with the cash flow statements, give an overall indication of the company’s performance and financial position.

 

The cash flow statement suffers from a number of drawbacks which may hinder its usefulness.

  1. It is based on historical information. Past performance might not be a reliable indicator of future performance.
  2. Cash flow statements are open to manipulation of cash flows, for example delaying payment to creditors beyond the year-end has a positive, but short-term impact on cash.
  3. While cash flow is important for a business to survive, so too is its ability to generate profit. Concentrating on short-term cash generation may be detrimental to investment in longer term projects which may be very profitable.

 

ADVANTAGES OF THE CASH FLOW STATEMENT

The cash flow statement provides information that is not available from the balance sheet and income statements.  In particular:

  1. It indicates the quality of the relationship which exists between the profitability of the business and its ability to generate cash.
  2. The present value of future cash flows can be used to value and compare entities. The availability of past cash flow statements can help assess the accuracy of these valuations.
  3. Cash flow is not affected by subjective judgement or by accounting policies.

 

  1. The cash flow statement helps users of the accounts to assess the likelihood and extent of future cash flows.
  2. It gives further indications of the liquidity of the business. Since the balance sheet is prepared in respect of a single day of the financial year, liquidity ratios calculated from it may be misleading.  The cash flow statement may give a more complete picture of the overall liquidity of the business.

 

SURMOUNTING A CASH SHORTAGE

If the entity appears to be generating insufficient cash amounts, there are a number of strategies it could possibly adopt, either individually or in combination.

  • Use or increase its overdraft facility
  • Increase its longer term borrowing
  • Raise cash through the issue of shares
  • Engage in tighter working capital management
  • Restrict large outlays on capital items; consider leasing instead
  • Sell non-essential business assets
  • Reduce dividends (usually a last resort)
  • Scale back activity levels (overall or in some sectors)
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